Fed comments and US debt ceiling breakdown deliver setbacks

All eyes on US debt ceiling talks as Fed rate hike expectations drop back.

USD: Fed comments & US debt ceiling breakdown deliver setbacks

The US dollar began the week with a slightly weaker stance, facing setbacks towards the end of the previous week. As a result, the dollar index retreated from its intra-day high of 103.62, falling back to around the 103.00-level. Despite this, the dollar still managed to end the week higher for the second consecutive time, a trend not seen since late February.

The first setback for the US dollar came from relatively dovish remarks made by Fed Chair Powell on Friday during the Laubach conference. Powell acknowledged that while there had been a clear need for further policy tightening in the past, the current policy stance is restrictive due to the progress made in tightening measures. He expressed concerns about the lagged effects of previous tightening and the potential impact of recent banking stresses on credit tightening. Powell emphasized the importance of carefully assessing data and the evolving economic outlook before making any decisions. He also acknowledged that the risks of doing too much or too little have become more balanced. When asked about the discrepancy between market expectations and the Fed's policy outlook, Powell did not strongly oppose the market's forecast of multiple rate cuts by the end of the year. He noted that the market's pricing is based on a different forecast regarding the speed of disinflation and the likelihood of a significant economic downturn. Powell maintained that the incoming data aligns with the Fed's view that it will take more time for inflation to subside, which is consistent with the views of market participants.

Overall, Powell's comments did not strongly indicate that the Fed is planning further rate increases at the next policy meeting on June 14th. Consequently, expectations for a June rate hike in the US rate market have diminished, with only a modest increase of around 2 basis points being priced in. (Note that still have time for Powell change his mind)

The second setback for the US dollar on Friday stemmed from a temporary breakdown in talks regarding the US debt ceiling. This development also contributed to the reduction in expectations for a June rate hike. This follows a recent call between President Biden and McCarthy and further discussions among key negotiators. The urgency to reach an agreement to raise the debt ceiling by the end of the month was emphasized by Treasury Secretary Yellen, who warned that some bills would go unpaid if the government breaches the June 1st deadline. The likelihood of the government being able to sustain operations and meet all obligations until mid-June is deemed quite low. The progress in US debt ceiling negotiations is expected to play a significant role in driving financial markets and foreign exchange movements in the upcoming weeks.

GBP: UK inflation set to fall back sharply in the week ahead

Looking ahead to the upcoming week, market participants will have their attention on the release of the latest UK Consumer Price Index (CPI) report on Wednesday and the US Personal Consumption Expenditures (PCE) deflator report on Friday.

The UK CPI report is anticipated to reveal a significant decline in headline inflation. According to the current Bloomberg consensus, headline inflation is expected to drop to 8.2% in April from 10.1% in March. This decrease will primarily be driven by disinflation in the energy price component. The 54% increase in the energy price cap for gas and electricity tariffs implemented in April 2022 will no longer be included in the annual inflation calculation. Ofgem, the energy regulator, is scheduled to announce the energy price cap for July to September on Thursday. It is expected to decrease closer to GBP2,000 from the current cap of GBP2,500 for April to June, further indicating that the negative energy price shock on the UK economy is diminishing.

Although the UK economy has shown greater resilience than expected to the negative terms of trade shock from last year, which led the Bank of England (BoE) to revise its recession forecasts for the UK, the CPI report is not likely to alleviate concerns regarding underlying inflation pressures. These pressures have prompted the BoE to continue raising rates, as there are fears that inflation could persist at higher levels. In their latest Quarterly Report projections, the BoE also expressed less optimism about the speed at which food inflation will decline this year. My forecast suggests one final 25 basis points hike from the BoE in June, and the recent BoE inflation forecasts have set higher expectations for upside inflation surprises in Q2.

As a result of the recent rebound for the US dollar, the British pound has retreated below the 1.25000-level against the dollar after reaching an intra-day high earlier this month at 1.2680. However, the pound has maintained a relatively stronger position against the Euro, with the EUR/GBP pair trading close to recent lows, just below the 0.8700-level. If underlying inflation pressures persist and support expectations for multiple rate hikes by the BoE, it could provide strength to the pound in the week ahead. Conversely, the main downside risk for the pound would be if underlying and food price inflation ease alongside the expected sharp decline in energy price inflation.